Tuesday, September 16, 2008

The VIX index, the measure of Wall Street's panic, rose this morning by enough to qualify this as a very serious problem. That's of course bad, but it's a good thing because it means that a great number of people have tried very hard to avoid risk (e.g., by buying put and call options, by selling, by hoarding cash) and so now they can sit back and wait for things to settle down.

In other words, the signs of panic and desperation are abundant, and sufficient for this to be the peak of the crisis. It needn't go much further, because this crisis is still limited to housing and banking. The basic problem is simple: people bought a lot of housing at inflated prices with borrowed money, and it's now going bust. There's no quick and easy solution to this problem, since the Fed would have to ease so massively as to reflate everything and thus stop the decline in prices. So we are unlikely to get rid of the problem soon, no matter what the Fed does today (I would not ease if I were Bernanke). Meanwhile, the market is dealing with the consequences of the problem. Housing prices are getting marked down and the market is clearing. Surely the financial markets have priced in and digested the great majority of the real estate losses. This can't go on forever and we've probably seen the worst.

Throughout all this housing price implosion, people have made the mistake of thinking that wiping out a big chunk of real estate wealth would have a huge negative impact on the economy, but it hasn't. They continue to worry about this, only now in spades. The economy is weak, but not dangerously so. Life goes on quite normally for most people. There are no systemic problems such as tight money or higher taxes or tariff wars to deal with this time. These are the classic economy killers Art Laffer always talks about.

The Fed holds a lot of the blame for all this. Easy money in the 2002-2005 period gave a boost to leverage strategies, housing prices, and all things physical. They've been trying to recapture the love, so to speak, by cutting interest rates, but it hasn't helped much, and that doesn't surprise me. You can't dial up inflation at will, it takes time and effort. Still, the CPI ex-energy rose 3.1% in the past year, and rose at a 3.4% rate in the past six months. This is an ongoing, but relatively moderate reflation that is making its way through the economy. Every day that helps narrow the gap between housing prices and reality; that lessens the pressure on housing prices to decline, by making them more affordable.

I don't agree with Gross that this will be a deleveraging implosion that leads to a massive or ongoing deflation. Once the losses are taken and the dust settles, life will go on as normal. We've got quite a few years of easy money in the pipeline that is waiting to show up in prices in coming years. Thank goodness oil has come down below 100! That takes a lot of pressure off, but $92 oil is still a sign that inflationary pressures are in the pipeline. Oil today is still 15% above where it was a year ago.